unit 1: trade theory heckscher-ohlin model 2/3/2012

Unit 1: Trade TheoryUnit 1: Trade Theory

Heckscher-Ohlin ModelHeckscher-Ohlin Model2/3/20122/3/2012

Heckscher-Ohlin ModelHeckscher-Ohlin ModelTrade occurs due to

differences in resources.

Countries have different relative abundance offactors of production.

Production processes use factors of production with

different relative intensity.

Heckscher-Ohlin: assumptionsHeckscher-Ohlin: assumptions1. 2 countries: home & foreign. 2. 2 goods: cloth & food.3. 2 factors of production: labor & capital.4. Mix of labor and capital used varies across goods.5. Supply of labor and capital:• constant in each country• varies across countries

6. Both labor and capital are mobile factors (long run).• equalize returns (wage & rental rate) across sectors

Heckscher-Ohlin: productionHeckscher-Ohlin: productionFig. 5-1: The Production Possibility Frontier

Without Factor Substitution

with more than 1 factor• OC no longer constant• PPF no longer straight line

Why?

PPF subject to 2 constraints:capital and labor

unit capital requirement unit capital requirement –number of units of capital required

to produce a unit of product

Ricardian Model: unit laborRicardian Model: unit labor

aKC ≡ unit capital requirement for clothaKF ≡ unit capital requirement for foodaLC ≡ unit labor requirement for clothaLF ≡ unit labor requirement for food



aKCQC + aKFQF ≤ KaLCQC + aLFQF ≤ L

QC ≡ output of clothQF ≡ output of foodK ≡ capital stockL ≡ labor stock



The production possibilities frontier is subject to both

constraints (capital & labor).

Without factor substitution, the PPF is the interior of the

two factor constraints.


Without Factor Substitution Max food (point 1) fully uses capital with excess labor.

Max cloth (point 2) fully uses labor with excess capital.

Intersection of labor and capital constraints (point 3) fully uses capital and labor.


Without Factor Substitution This example has 2 opportunity costs:

low OC (2/3) when the PPFis on the capital constraint with low cloth / high food

high OC (2) when the PPFis on the labor constraintwith high cloth / low food



aKCQC + aKFQF ≤ KaLCQC + aLFQF ≤ L

PPF equations don’t allow for factor substitution

(unit factor requirements are constant on constraints).

Heckscher-Ohlin: productionHeckscher-Ohlin: productionFig. 5-2: The Production Possibility

Frontier with Factor Substitution

Allowing factor substitution leads to a curved PPF.

Opportunity cost increases continuously as producers

make more cloth.

Heckscher-Ohlin: productionHeckscher-Ohlin: productionFig. 5-3: Prices and Production

Economy produces at the point that maximizes the

value of production.

This occurs where an isovalue line is tangent

to the PPF (point Q):relative price (-PC/PF) =

opportunity cost(PPF slope)

Heckscher-Ohlin: productionHeckscher-Ohlin: productionFig. 5-3: Prices and Production

V = PCQC + PFQF

QC ≡ output of clothQF ≡ output of foodPC ≡ price of clothPF ≡ price of foodV ≡ total value-PC/PF ≡ slope of isovalue

Fig. 5-4: Input Possibilities in Food Production

Heckscher-Ohlin: mix of inputsHeckscher-Ohlin: mix of inputs

With factor substitution producers can choose

different mixes of laborand capital to produce food:

• less capital & more labor; or• more capital & less labor

Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor pricesFig. 5-5: Factor Prices

and Input Choices

Producers’ choice of factor mixes will depend on the

wage rate (w) and therental rate of capital (r).

As w increases relativeto r, producers will use

more capital and less labor.

Fig. 5-5: Factor Pricesand Input Choices

Assume at any given w/r:aLC/aKC > aLF/aKF or

LC/KC > LF/KF

So cloth uses more labor relative to capital than food.

Cloth is labor-intensive;food is capital-intensive.

Cloth curve right of food curve.

Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor prices

Fig. 5-6: Factor Pricesand Goods Prices

In competitive markets, the price of a good depends on its

cost of production, which depends on the price of factors.


Fig. 5-6: Factor Pricesand Goods Prices

Changes in w/r are tiedto changes in PC/PF:

change in r affects capital-intensive good more,

change in w affects labor-intensive good more.


Fig. 5-6: Factor Pricesand Goods Prices Stolper-Samuelson theorem

If the relative price of a good increases, then the real wage

or rental rate of the factor used intensively in the

production of that good increases, while the real

wage or rental rate of the other factor decreases.


Fig. 5-7: From Goods Prices to Input Choices


By rotating the graph in figure 5-6 it can be

combined with the graph from figure 5-5 (both

have w/r as the y-axis).


Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor pricesIncreasing the relative

price PC/PF moves to the left on the SS curve in the

left graph, which increases w/r. When w/r

increases, move to the left on the FF and CC

curves in the right graph, decreasing L/K.



Increasing the relative price PC/PF increases w/r

(the relative nominal income of workers to

capital owners).



Increasing the relative price PC/PF decreases L/K (ratio of labor to capital)in both cloth and food,

which means K/L goes up(ratio of capital to labor) in both cloth and food.



More capital per unit of labor increases MPL

(labor more productive).

Less labor per capital decreases MPK

(capital less productive).


Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor pricesIn perfect competition

factor price =factor productivity

x good price.

w = MPLCPC

w = MPLFPF

r = MPKCPC

r = MPKFPF


Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor pricesReal income of factors

will equal factor productivity.

w/PC = MPLC

w/PF = MPLF

r/PC = MPKC

r/PF = MPKF


Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor pricesWe saw that increasing PC/PF leads to increasing

w/r, which decreases L/K for both goods.

Decreasing L/K means MPLC & MPLF increase;

MPKC & MPKF decrease.

So w/PC & w/PF increase;r/PC & r/PF decrease.


Heckscher-Ohlin: factor pricesHeckscher-Ohlin: factor pricesSo increasing PC/PF means:

raise income of workers relative to capital owners,

lower ratio of labor to capital in both industries,

raise real income of workers and lower real

income of capital owners.



PC/PF↑ →

(w/r)↑,

(L/K)↓, (K/L)↑,

(w/PC)↑, (w/PF)↑,

(r/PC)↓, (r/PF)↓

Heckscher-Ohlin: resourcesHeckscher-Ohlin: resourcesFig. 5-8: Resources and Production Possibilities Rybczynski theorem

If you hold output prices constant as the amount of a

factor of production increases, then the supply of the good

that uses this factor intensively increases and the supply of the

other good decreases.

Heckscher-Ohlin: resourcesHeckscher-Ohlin: resourcesAssume L grows, L/K increases.

PPF expands, biased towards cloth.(increase in L/K rises max cloth more than max food becausecloth is more labor-intensive)

PC/PF stays constant, so L/K used in both sectors remains constant.

Fig. 5-8: Resources and Production Possibilities

Heckscher-Ohlin: resourcesHeckscher-Ohlin: resources

To employ the additional workers, the economy expands production of the relatively labor-intensive

good cloth and contracts production of the relatively capital-intensive good food.



Each shift of a unit of capital from food to cloth employs more units of labor because

cloth is more labor intensive.

This soaks up excess laboruntil all resources are fully

employed.



An economy with a high ratio of labor to capital produces a high output of cloth relative to food.


L/K > L*/K*

Home is relativelyabundant in labor

Foreign is relatively abundant in capital

Fig. 5-9: Trade Leads to a Convergence of Relative Prices

Heckscher-Ohlin: tradeHeckscher-Ohlin: trade

L/K > L*/K*

Home is relativelyscarce in capital

Foreign is relativelyscarce in labor



L/K > L*/K*

Home will be relatively efficient at producing cloth because cloth is

relatively labor intensive.

Foreign will be relatively efficient at producing food because food is

relatively capital intensive.




Heckscher-Ohlin: tradeHeckscher-Ohlin: tradeCountries are assumed to havethe same tastes and therefore

identical relative demands.

Countries are assumed to have the same technology and therefore a

given mix of capital and labor yields the same output of cloth and food in the two countries.



Each economy has a comparative advantage in producing the good

that relatively intensively uses the factors of production in which the country is relatively well endowed.

Home is labor abundant.Foreign is capital abundant.



Since cloth is relatively labor intensive, at each PC/PF, Home’s

QC/QF will be higher than Foreign.

Home’s relative supply curvelies to the right of Foreign’s.



The Heckscher-Ohlin model predicts a convergence ofrelative prices with trade.

With trade, PC/PF rises in the relatively labor abundant (home) country and falls in the relatively

labor scarce (foreign) country.



Home: the rise in PC/PF leads to a rise in the relative productionof cloth and a fall in relative

consumption of cloth.

Home becomes an exporter of cloth and an importer of food.



Foreign: the fall in PC/PF leads to a fall in the relative productionof cloth and a rise in relative

consumption of cloth.

Foreign becomes an exporter of food and an importer of cloth.


Heckscher-Ohlin: tradeHeckscher-Ohlin: tradeHeckscher-Ohlin theorem

An economy has a comparative advantage in producing, and thus

will export, goods that are relatively intensive in using its relatively abundant factors of

production and will import goods that are relatively intensive in

using its relatively scarce factors of production.

Heckscher-Ohlin: factor convergeHeckscher-Ohlin: factor convergeUnlike the Ricardian model, the Heckscher-Ohlin model predicts

that factor prices will be equalized among countries that trade.

Free trade equalizes relative output prices; the model links

output prices to factor prices; thus factor prices are also equalized.

Heckscher-Ohlin: factor convergeHeckscher-Ohlin: factor converge

In the real world, factor prices are not equal

across countries.

Why not?

Some model assumptions are wrong.

Heckscher-Ohlin: factor convergeHeckscher-Ohlin: factor convergeAssumptions… realities• countries produce the same goods

o may specialize (different goods)• countries have same technologies

o may have different technology• price equalization in goods due to trade

o trade barriers & transport costs• factors instantly move among sectors

o short run factor stickiness

Leontief paradox Leontief paradox –U.S. exports were less capital-

intensive than U.S. imports, even though the U.S. is the most capital-

abundant country in the world

This holds internationally: trade often doesn’t run in the direction

predicted by Heckscher-Ohlin.

Heckscher-Ohlin: empirical testsHeckscher-Ohlin: empirical tests

Heckscher-Ohlin: empirical testsHeckscher-Ohlin: empirical testsThe model also predicts a larger volume of trade than is found.

These problems probably stem from the assumption of common technology, which is unrealistic.

Patterns of exports between developed (high income) and

developing (low income) countries fit the theory quite well.

Fig. 5-12: Skill Intensity and the Pattern of Imports from 2 Countries

Heckscher-Ohlin: empirical testsHeckscher-Ohlin: empirical tests

As Japan and the four Asian “miracle” countries became more skill-abundant, U.S. imports shifted from less skill-

intensive industries toward more skill-intensive industries.

Fig. 5-13: Changing Patternsof Comparative Advantage

Fig. 5-13: Changing Patternsof Comparative Advantage

unit 1: trade theory heckscher-ohlin model 2/3/2012

Documents

labor capital

constraints capital

capital constraints

excess capital

factor constraints

factor oc

excess labor

mix of labor